Fed raises interest rate to 1.25% and warns of more to come

America's long downward march in short-term interest rates ended yesterday as the Federal Reserve raised its key short-term rate by 25 basis points. The central bank indicated it hoped to keep future increases modest, but warned it would take sterner action if needed.

America's long downward march in short-term interest rates ended yesterday as the Federal Reserve raised its key short-term rate by 25 basis points. The central bank indicated it hoped to keep future increases modest, but warned it would take sterner action if needed.

In the first increase in more than four years, the Fed announced after a two-day meeting here that the target for the benchmark federal funds rate is going up to 1.25 per cent from 1 per cent, where it had stood since May 2003 - the lowest level since the late 1950s.

The move is expected to usher in a period of steadily rising rates in the US, matching an economy that has pulled out of recession and where inflation is emerging again as the main threat to stability.

In the closely watched statement issued after the Federal Open Market Committee meeting, the Fed underlined its goal of conducting the future tightening at "a measured pace". Upside and downside risks to the economy were "roughly equal", the statement said.

But it gave a clear signal that if the inflationary outlook worsened, the central bank would not hesitate to act. The FOMC, it said, "will respond to changes in economic prospects as needed to maintain its obligation to reserve price stability".

"This is a dovish statement," Alan Blinder, a former Fed vice-chairman said. "They kept the 'measured pace' and did not say that inflation was moving dangerously ahead." Indeed, the statement noted that much of the recent spurt in inflation - to an annual rate of 3 per cent - was due to "transient" factors such as the higher price of oil and energy products.

The move had been massively trailed by Alan Greenspan, the Fed chairman, and other senior officials. Wall Street reacted phlegmatically, with the Dow flat after the announcement. Indeed, the only debate beforehand was whether the central bank would kick off the new cycle with a 50-point increase, instead of the generally expected quarter percentage point rise.

The international ramifications are also likely to be limited - for the time being at least. The Bank of England has been raising rates for months, while Canada and Australia were already expected to follow suit. The decision does take pressure off the European Central Bank to cut its 2 per cent rate.

The increase is likely to be the first of several, stretching into and probably through 2005. Bond markets, which have weakened lately on inflation fears, have already priced in a rise in the fed funds rate to 2.25 per cent by the end of 2004, and to more than 3.5 per cent during 2005.

But with inflation running at 2 per cent by the GDP deflator, and 3 per cent according to the latest retail price index, short-term rates will continue to be negative in real terms, probably until the end of the year.

The increase reflects a US recovery which is now generating steady annual growth of 4 per cent. Forecasters say the June employment figures are likely to show another solid gain, on top of the 1 million jobs created between March and May alone.